China’s Gradual Economic Reform and Opening to Trade (1978-1992) Dual Track Economy

Starting in 1978 the Chinese economic policy makers slowly phased in market prices. They used a dual

price system where production quotas are set and the output is sold to the state at the (usually lower)

state administered price, and any "over quota" production is sold in the market at the market price.

Similarly consumers were allocated ration tickets allowing them to buy their personal quota of goods at

the low state price. To the extent that they wanted to consume more than their quota, they could buy it

without a ration ticket in the free market. Over time the administered prices slowly rose to the market

price, ration tickets where reduced and by the middle 1990s the ration tickets were discontinued and

most consumer goods were bought and sold at market prices. Still, key sectors of the economy

remained under price controls. These sectors include the banking sector (interest rates fixed), air

transport (fares are computed based on the kilometers of the flight), steel, coal, petroleum, gold, etc..

The positive effect of this approach is that it established market price signals from the very beginning.

These price signals served their informational purpose of guiding economic behavior at the margin. A

major disadvantage of the dual price system is that created large opportunities for corruption by the

officials in charge of distributing the goods to be sold at the low administered prices. These officials then

had vested interests to protect and may have been instrumental in slowing the reform process.

Proportion of Products Sold at Different Kinds of Prices

1978 1986 1990 1992

Retail Sales

At State Price 97 NA 46.9 10

At Market Price 3 NA 53.1 90

Agricultural Sales

At State Price 94.4 NA 47.8

At Market Price 5.6 NA 52.2 57.8

Industrial Sales

At State Price 100 87 63.2

At Market Price 0 13 36.8 65

Family Responsibility System (early 80s)

Local villages were allowed to experiment with the Family Responsibility System whereby the collective

land was divided and allocated for use by individual families. To make the allocation fair, the land was

allocated according to family size. Each family was given equal shares of good bottom land and not so

good hillside land. Each family was responsible for its share of the collective's quota (sold to the

planners at the low state price), and could use the rest of their resources to produce goods for the

market. Peasants used the market prices to determine where to allocate their resources...pigs, chicken,

fresh vegetables and so on. For villages located near large cities, this system provided large competitive

free markets. And urban consumers were increasingly buying at the free markets as their ration tickets

were reduced. Two obvious results are that incentives changed, and that plots of land were fragmented

so that scale economies were lost. While villages were not forced to make this change, by 1983 the vast

majority of villages had adopted it. Agricultural production soared during the first years of the reform.

Some argue that the growth in agricultural output was due to the phenomenal increase in the

application of chemical fertilizers, but this increase itself was primarily the result of the reforms. This

initial boost, however, was a one shot affair and further increases in agricultural production would only

come with more reforms. As long as peasant productivity remains low, peasant income will remain low

and lag behind the income growth of the cities. As the US experienced in the 1930s, reducing the

farming population is a difficult process.

Town & Village Enterprises (80s)

Before 1978 many of the village collectives did more than just grow crops. With the surplus labor and

high rates of savings, and insufficient allocation of inputs (from the central plan) these collectives had

often allocated resources to small village enterprises. For example, a collective may have a small

fertilizer producing facility, a brick works, or a catfish pond. With the opening up of free markets, these

collective facilities evolved into collectively owned businesses which were called Town and Village

Enterprises (TVEs). While these TVEs were not privately owned, they were market driven and guided by

market prices. They were sometimes the recipients of foreign direct investment. What we would call

profit, stayed within the collective to be used for schools, parks, old age assistance, etc. It is a little

known fact the real force behind the Chinese economic growth of the 1980s was the TVE. TVEs faced

market prices, harder budget constraints, and were controlled more by local managers than the large

state owned enterprises. Still, the TVEs have the potential for inefficient behavior when compared to

private enterprise. In many cases local officials interfered with decisions to cut back employment. And

since profits are not claimed by stock holders who can sell their stock, these enterprises can earn less

than their opportunity costs without control by stockholders. In this way, the budget constraint facing

TVEs was not as hard as for privately owned firms.

Share of Industrial Output by Ownership Type

1981 1985 1990 1994

State Industry (SOE) 78.3 70.4 54.5 37.3

Collective (TVE) 21.0 27.7 35.7 37.7

Individual and Other .6 1.9 9.7 25

State Owned Enterprise (SOE) – “Growing Out of the Plan”

The state owned enterprises were the center pin of the old planning process. They tended to be huge

and geographically located according to planning rather than market criteria. The typical SOE was a

walled community which provided housing, health care, schooling, pensions and other social services to

its workers. There weren't many reasons for a worker to leave the walls which surrounded the SOE.

After 1978 the SOEs continued to operate almost unchanged. But there was also a sort of "family

responsibility system" for the SOE. Once they satisfied the quota for the plan they were free to sell "out

of plan" output in the free market. Here the SOE had some incentive to pay attention to market signals.

Still the SOE's were certain to get bailed out if they couldn't meet their expenses by "loans" from the

state owned banking system. So the SOEs continued to operate under a soft budget constraint with the

expected poor incentives and low efficiency. As the reforms moved into the late 1990s, the government

was showing that it was increasingly willing to let some of the most egregiously loss making SOEs close

down. Workers of a closed SOE were suddenly unemployed and looking for work for the first time in

their life. They also had lost any claim to a pension since the old policy was that the SOE provided the

pension and the central government has not initiated much of a national pension plan. This also cut

some workers off from their traditional source for medical care. Regionally the unemployment rate can

be as high as 30%, especially in the Chinese rust belt. For some regions of China, economic activity was

the result of planning. For example large heavy industrial plants were built in remote Gansu province. A

large number of workers were sent to Gansu under the plan. Once the planning sector is reduced and

these heavy industrial plants are allowed to fail, the reason for much of Gansu's industrial activity

ceases. Under the market regime, located heavy industry so far from the markets isn't rational. Thus

despite China's steady economic growth, there are substantial regions of the country experiencing full

scaled depressions which rival those observed in Belarus or the Ukraine. The data charted below

indicate the progress made at reforming state owned enterprise. While the SOE's share of industrial

output has fallen since the onset of reforms, the allocation of investment funds via the stat e controlled

banking sector did not begin to fall until the 1990s. In the 1990s, with both output share and investment

share for SOEs falling, the fall in the % employed in state industry has been slow to fall and in absolute

numbers, has actually risen during this period. The lagging productivity in a large portion of SOEs has

remained a difficult problem. For the last 30 years or so, under the soft budget constraints of planning

and partial reform, many SOEs have been kept afloat when, based on narrow market efficiency

measures, they should have been allowed to fail.

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The Trade Sector during the Early Reforms (1978-1992)

Special Economic Zones

Starting in 1980, China opened several SEZs in southern China close to Hong Kong (and

Taiwan). Producers in these zones could import materials and components free of many

regulations and tariffs. The Chinese government also provided substantial subsidies for

infrastructure. In 1984, China established similar arrangements in 14 other coastal cities.

Exchange Rate Devaluation

Like most other planned “socialist” economies, the China’s exchange rate was overvalued

at the beginning of the reform. The over valued exchange rate subsidized the importation

of capital goods needed for the economic plan. It also led to an excess demand for foreign

currency, a rigid system of controls, limitations on who could legally hold foreign

exchange, and a vibrant black market.

During the 1980s, Exporters were helped by a substantial devaluation of the official exchange rate,

from 1.5RMB/$ in 1981 to 8.3RMB/$ in 1995. While China did experience higher rates of inflation

than the US, the IMF states that this represents a 70% devaluation in real terms.

1978-93: Dual exchange rate (FEC & RMB) From 1986 to the mid 1990s, China used a dual currency system. Chinese could legally hold and

transact only in RMB (people’s money). Foreigners and imported products could use Foreign

Exchange Certificates.

FEC

RMB

Demonopolization of Trading Companies

Throughout the 1980s China continued to restrict the rights to engage in trade. Still, that

was an increase in the number of firms allows to conduct international firms, from 12 in

1978 to 5000 in 1988.

Tariffs

Tariffs actually increased during the early 1980s. This was part of a longer term strategy of

first turning non tariff barriers into tariff barriers, and then, reducing the tariffs en route

to ultimate membership in the WTO (finished in 12/2003). While China’s tariffs were high

in the early 1980s, they were not unusually high for a developing country.

Corruption

While the gradual reforms can be said to have ushered in markets and trade to avoid

unsustainable, short term shocks, the two track system opened the door to what is usually

labeled as corrupt behavior.